Let’s face it, budgeting can be a pain. Most people get too discouraged trying to get a budget to work. They spend hours trying to figure out how much to budget in each category and may even track every penny spent during the month only to find out that reality didn’t match what was budgeted. In these instances budgeting just seems like a futile theoretical exercise. There’s no follow up or reconciliation to tie one month’s budget to the next. Add to this the emotional issues that budgeting can trigger and your chances of maintaining a budget dive bomb. Many people who get to this point just give up and quit.

Why most budgets don’t work

There are three major problems with a common budget:

They don’t reflect reality.

They don’t connect from one month to the next.

They don’t track the surplus money left over after all the categories are filled.

1. Most budgets don’t reflect reality

Budgeting is an exercise in being wrong. Every time you sit down and write out all your categories and how much you think you’re going to spend, you’ll be wrong. Being wrong month after month quickly can get discouraging and many people give up. What’s the point in trying to predict how much you’ll spend each month if you know you’ll be wrong.

So you overspent. Ok, at least you know you overspent and that could be helpful in planning next month but where did that overspent money come from? How are you going to reconcile the difference?

Unfortunately there’s no way around being wrong. There’s really no solution besides developing obsessive tendancies and even then…good luck. You must first accept that you’ll be wrong…every month. My wife and I have never been right even though we’ve had an established budget for years. Accept it.

Now I’m NOT saying you won’t start getting really close. In fact, in many categories you will be right. But so far I’ve never been 100% right. Don’t get discouraged if you’re just starting out because for the first few months you’ll be REALLY wrong. It took us about 3-4 months until we started getting into our budget groove.

One way to get your budget closer to reality is to allocate every dollar of your income. If you have money left over after addressing your needs, allocate it. I don’t care where; put it in a “fun” category or direct it towards meeting a financial goal. Don’t just say “oh, I have leftover money. I must be doing really good at budgeting.” If you don’t allocate everything you will end up wasting that which is left over and your budget will be broken from month to month.

Another way to close the reality gap is to be realistic about what your needs are. Things like shelter, clothing, and food are not optional. Many people have unrealistic expectations about what they will spend on these categories. I’m certainly an advocate of being thrifty and looking for good deals but you can only take it so far. If you refuse to face how much you really need to spend in these categories to survive without eating ramen every night, your budget will not be an effective tool.

Yet another way of helping your budget reflect reality is to make sure you have a way of dealing with the difference between your budget and actual spending. And that leads us into our second problem.

2. Most budgets don’t connect one month to the next

Quicken is a great example of why this problem exists. Quicken’s budgeting feature seems great. It allows you to easily enter budget amounts and will even pre-populate projected amounts for you. At the end of the month you can run a nice neat report telling you how much you over or under-spent. There’s just one problem. There are no tools for helping you deal with the difference (if there are, please let me know about them). You just enter in the next month’s budget amounts using the exact same process and projections as the month before. This makes for a nice, neat, pretty budget sheet but not a very useful one.

Many people think a budget is a static document. You fill out one template reflecting all your categories and how much you should spend each month and use the exact same sheet from month to month. That’s not a budget. It’s a dead document. A real budget is a living document or series of documents. It changes from month to month and should be a reflection of reality, not a theoretical exercise.

The fact is, your expenses change from month to month. Car registrations sneak up on you. Unexpected birthdays pop up. Unexpected expenses happen. And you can’t always just take your yearly expenses and divide by 12. If your car registration is coming up in 3 months and you haven’t saved anything for it, dividing by 12 will only leave you with a quarter of what you need to pay it. The unique expenses for every month need to be dealt with individually, not just from a nice clean Quicken projection.

For a budget to work, you must link one month’s budget to the next.

Is there too much money left over? Great. Where does it go? Should we pay off debt, save for retirement, save for a vacation, or just blow it and buy that new toy? I’m not against throwing caution to the wind as long as it’s done conciously and not by default.

Is there too little money to cover all our spending? Where did it come from? Will we be spending less on groceries, lowering our savings contribution, or going into more debt?

3. Most budgets don’t track the surplus money left over after all the categories are filled

For a budget to work, you must allocate ALL of your income to categories. As Dave Ramsey puts it, you must “spend your whole month on paper” before you spend it in real life. Other analogies that come to mind are Stephen Covey’s concept of the spiritual creation before the physical creation and David Allen’s idea of writing down EVERYTHING that is on your mind so you can get it out of your head and on paper.

Stephen Covey Comparison

Let’s look at the Covey analogy. Covey says that you should “begin with the end in mind.” One way of doing so is to create what you’re trying to achieve spiritually first, and then physically. A builder doesn’t build without a blue print. You should have a good idea of where you want to go either on paper or in your mind before you set out. Doing so makes your efforts more effective.

When it comes to finances, by writing ALL YOUR PLANNED SPENDING down on paper first (spiritual creation), your chances of actually following your plan significantly increase (physical creation). You’ll also be much more likely to achieve your larger financial goals (physical creation).

David Allen GTD Comparison

Now let’s consider David Allen’s idea of capturing everything on paper. He teaches that you should get anything and everything down on paper that occupies your mind. Doing so frees up “mental RAM” and allows you to spend your time more effectively rather than eating up endless mental cycles on the same issues, questions, and to-dos.

Similarly, by writing down how you are going to spend every dollar, you free yourself from mental worry and guilt and allow yourself to think about much more enjoyable things. Combine this with using cash for those categories that tend to be out of control and you can literally eliminate financial worry and anxiety. Every dollar you spend will be focused and controlled with very little effort.

No matter how you want to look at it, you need to allocate EVERY SINGLE DOLLAR ON PAPER for a budget to be of maximum effect. Why? Doing so forces you to really think about where you want your money to go and insures you use each dollar to it’s fullest. You’ll probably notice that when you don’t allocate every dollar, your left over dollars usually end up spending themselves. You end up with nothing to show for it, not even the concious realization that you had fun wasting that money.

Spend frivolously and feel good about it

By saying that you need to allocate every single dollar, I’m not saying you can’t have fun with your money or spend frivolously. Go ahead and conciously decide to have fun or even waste the leftover money. Allocate it as “fun” money to be spent however you want, whenever you want. By doing so you may enjoy spending that money even more. You’ll be able to do so with confidence and no guilt that you should be spending it elsewhere.

Decide before you’re in the heat of the moment

Like using cash, allocating all your funds allows you to make more concious decisions about where your money should go. Instead of waiting until you’re standing at the register, you can decide where your money will go while your looking at the big picture. Your decisions will be more rational and less emotional. You will also be able to direct your money towards meeting your larger, longer term goals. Instead of pittling money away, save for that new car or piece of furniture. Or for real financial peace, pay off debt.

Harness the power of focus

Allocating every dollar allows you to harness the power of focus. Take your plumbing, for example. Water by itself isn’t very useful in a puddle or lake. But give water the contraints and focus of a pipe and all of a sudden it can be used for your toilet or sink. Focus water through a hose and you can water your lawn or put out a fire. The constraint actually makes the water more powerful and useful. Similarly constraining your money by allocating every dollar makes your money more useful and powerful. Your ability to save and reach your goals will be increased.

See if you can identify with this personal example. Before we got our financial acts together, every time we recieved a bonus, raise, gift, or other unexpected income the money would just seem to slip through the cracks. Most people tend to expand their lifestyle to meet their income. In contrast, imagine if you were able to focus and direct every extra dollar. Every time you got a bonus, heck, every time you saved $5 on your phone bill, you would be able to easily redirect that money to another purpose. Your power and ability to aggressively meet your financial goals would increase dramatically. Without an effective budget, what is the point of trying to save a few dollars when they disappear anyway. But with an effective budget every dollar counts and is directed exactly where you want it.

Another benefit of allocating every dollar is that your budget will reflect reality more closely. If you have money left over after allocating your needs, that extra money almost always WILL be spent one way or another. If your budget doesn’t reflect that, it doesn’t reflect reality enough to be effective. To eliminate financial stress and a sense of being out of control once and for all you MUST KNOW where your money is being spent. You must TELL IT WHERE TO GO rather than letting it decide.

Using a Zero-Based Budget

A critical tool to help solve these basic budget blunders is the zero-based budget. Now if you’re expecting something flashy, you’ll be disappointed. A zero-based budget simply means that you allocate every dollar of your income so that your income minus your expenses equals “zero.” It’s as simple as that. No special forms or fancy software are necessary. Using a zero-based budget forces you to allocate every dollar and will help your budget more closely reflect reality.

Always track and DEAL WITH the difference between “budgeted” and “actual”

Make sure you follow up at the end of every month and write down what the difference is in each category between what you budgeted and what you actually spent. You then need to deal with that difference. Don’t just look at it and say “oh, there’s a difference. Good to know.” You must either reallocate the money on paper or carry the difference over to your next month’s budget.

For example, if you spent $5 more on your phone bill than you thought (a common occurance since the phone bill tends to be quite variable), you must spend $5 less in another category. One option is to see if you spent $5 less than you thought in another category that month. If so, simply adjust your allocations on paper. If there is no unspent money in your categories then you need to carry that $5 over to the next month and allocate $5 less in a category for your next month’s budget.

Implement a “grease” category

To deal with small instances of overspending, I always budget a “grease” (a.k.a. “blow,” “cushion,” “RealityBites”) category of about $100 that gives me a cushion in dealing with such instances. Since you know you’re going to be wrong (see above) you might as well plan for it. This account acts like the “grease” that keeps the financial gears turning. It picks up my slack. And if I have extra “grease” money left over at the end of the month, it directly gets realocated for something else the next month (often something fun as a little reward).

Putting it all together

I realize that I’ve skipped over many specifics. Implementing some of these concepts may seem a bit confusing at first. If so, no worries. I’ll be addressing specifics in future posts. For now, let me summarize the steps you can take today:

Implement a zero-based budget. Stay tuned for examples and templates.

Allocate every dollar of income to a category. When you subtract your budgeted expenses from your income, it should equal $0.

Be sure to budget a “grease” category to deal with minor inaccuracies.

Be realistic about how much you are going to spend on necessities. Most people under-allocate in the categories of food, clothing, and transportation.

Know that your spending won’t exactly match what you budgeted. If you are just starting, you may be WAY off. That’s ok. Do a little, learn a lot. It WILL get better. If you’re married, be easy on your spouse.

Calculate the difference between “budgeted” and “actual” spending and either adjust the current month’s allocations or deal with the difference in next month’s budget. I realize there are some BIG procedural holes and questions here that I’m skimming over for now. Stay tuned.

19 Comments to “3 reasons most budgets don’t work and how to fix them (a.k.a. How to create a budget that works)”

Here are interesting posts and news this week from the MoneyBlogNetwork members and beyond: Blueprint for Financial Prosperity reviews Invest In Your Nest. Consumerism Commentary shared his personal income statement. AllFinancialMatters started the que…

Financial weblog Getting Finances Done suggests that there are generally 3 reasons most budgets fail: They don’t reflect reality. They don’t connect from one month to the next. They don’t track the surplus money left over after all the…

[…] For the geek in all of us…ok, the geek in me, there is Getting Finances Done. This is a mixture of a personal finance blog and David Allen’s Getting Things Done methodology which basically makes it the geek equivalent of a speedball. Getting Finances Done has been immensely helpful in the development of my personal budget. I highly recommend 3 Reasons Why Most Budgets Don’t Work (and How to Fix Them) and the excellent follow-up piece, How to Create a Zero-Based Budget. […]

You know, my problem isin’t that my budget isin’t sound, it’s that I just can’t seem to track all of my expenses. I find myself queering my bank account and asking myself where I spent it all. Great read none the less, learned a few things that I noticed I had been doing.

Great article! I have one question. The article says that you can’t always just take your yearly expenses in different areas and divide by 12. How come? I’m aware of, like the text said, that if my insurance for the car is comping up in 3 months I will only have a quarter of the money I need. But that will only be a problem the first time when I start budgeting, right? For the next year I will sort of already be in the cycle and have 12 months of savings for the car insurance the next time? Am I totally off here?!

Fredrik,
You’re right. If you have a full 12 months before the next yearly payment, you can just divide by 12. The problem comes when people are starting their budget and they divide by 12. If there aren’t a full twelve months before the payment, they’ll come up short.

[…] Build a Better Budget July 24, 2008 Filed under: finances — redykle @ 10:51 am I’ve heard that the average household spends 10% more than they make. Having been guilty of that many many months, I’ve been working with PL over the past three months to build a household budget, cut expenses, and live within the budget. The real test starts August 1st when we pledged to stick to our budget with no cheating by moving money around from savings to checking. We’ll only have one job in the family for the next three years, plus a little extra money coming in through student loans and mileage reimbursements for work (and whatever my wonderful and generous mom shoves in my hand when I come to visit-she doesn’t even know I have a blog and I’m still nice) so living within our budget is really critical. The first part of the project was to start figuring out where in the world our money went and why we spend so much of it. Starting in April and continuing in May and June (and looking back from January to the present too since I got bored at work one day), I looked at all of our bank statements and credit card bills and wrote down every expense and it’s category in a spreadsheet. Of course I had no clue if the money spent at the grocery store was all food or household supplies or personal care items, but that’s ok for now. There’s a lot of free templates for expenses and budgeting on the interwebs, but I didn’t find one that listed the way that I wanted to categorize things and I found myself adding and deleting lots of things. So, I built a simple spreadsheet, showing my actual take home pay (since my real pay is only important to me on my W-2 and I just want to know how much money I can spend) and any other sources of money that came in and refecting the categories of spending that made sense to me. Here’s my budget, with the actual specifics of our income and expenes taken out. For example, I wanted to separate yard/garden stuff out from other household things since I like buying plants but know flowers aren’t as essential as laundry detergent. I don’t buy many clothes or go see many movies, but I do sometimes pay an tattooed guy in an indie rock band $45 to cut my hair. This excercise was simple enough, but shocking. Ordering pizza on Thursdays when we were too tired to cook, stopping at Subway on the way home from church since we hadn’t been grocery shopping, and other excuses for not eating at home added up to almost $200 a month! Doing this was also helpful because we took the time to figure out ways to save money on “fixed” expenses like internet and tv. We ditched the satellite dish and landline, and got cable internet from a different company and signed up for just the local channels. (Side note: They gave us the regular channels anyway for the same price when they hooked it up, so our secondary reason for ditching the cable in hopes of watching less tv and playing more games and reading more didn’t work out as we had planned. We still get Bravo, USA, TNT and any other channel that shows Law and Order constantly, so we’re still lazy bums. Who am I kidding? Even a few years ago when we only had 3 channels and rabbit ears, I would still watch too much tv. Golf is surprisingly fascinating when it’s the on the only channel with a clear picture.) The next step was to start projecting how much money we should expect to be spending in each category, starting first with those things like the mortgage that are the same every month and easier to predict. Our year to date history of power bills and gas bills helped me to get to an average amount to budget, but that will always vary from month to month. This is the part of budgeting where I think most people get stuck, fail, and give up. After tracking how much money we were spending, I was really excited to set some goals for cheaper grocery bills and less going out to eat, but quickly got frustrated when we realized it was time to get the oil changed in both cars, we had to buy a present for a wedding shower (I wish it wasn’t rude to just not buy people presents for special occasions), and the cat had to go to the vet and get one really expensive staple. Budgets don’t work. Why don’t they work? There’s a great article on this at Getting Finances Done, that I suggest you read but their answer is this: There are three major problems with a common budget: 1. They don’t reflect reality. 2. They don’t connect from one month to the next. 3. They don’t track the surplus money left over after all the categories are filled My main budgeting challenge is trying to figure out a way to account for expenses that don’t occur every month like new glasses and contacts and car registrations, and to make sure we have money for those expenses when they come up. Emergencies do happen, but those things aren’t emergencies. Budgeting programs like Quicken don’t take into account that a budget changes slightly from month to month-they just copy one month’s projection over to the next. My solution was to stick with my same budget spreadsheet and add a yearly column beside my monthly one. I only get glasses once a year, but I can guess the amount they will cost each time (a lot) and put that in the yearly column. I then divided it by 12 and put it in my monthly column. My goal is to put any surplus money in the months when those expenses don’t happen into the savings account so it’s there when it is time to pay for those things. That’s a budgeting strategy called building a zero based budget, where every cent is allocated each month. The extra money can go into the entertainment budget if there’s enough, but without allocating it, it just disappears somehow and you don’t even remember having fun spending it. How do I plan to keep up with all of this? Our checking account, savings account, and main credit card are all with the same bank and show up on a single online banking screen. I check my other investment accounts regularly, but don’t want to think of them as money available for expenses. I know a lot of people want everything in one place but my main goal is improving our day to day spending, so I’m not concerned with those. I also avoid having cash, since I’m a cash black hole. On the occasions when I do have cash and need it for something, I want to do better about keeping the reciepts and treating it just like regular spending. This bank’s bill pay works well, we have direct deposit, and we pay EVERYTHING online. I can’t even find the checkbook most of the time. We can’t receive e-bills from our gas company and the county’s water bill still comes in the mail too, but we can pay them online. Our bank’s e-bill system can even cut checks to individuals. We also have another credit card with rewards that we now use for most of our day to day expenses in order to get grocery and gas money back. That’s a newer card so we’re still getting used to using that and not the debit card, and trying not to spend 2x the money by using it AND the debit card. Since our income and expenses clear the account so quickly and you can view them online within the day, I plan to manually fill in the spreadsheet as we go along. I uploaded it as a Google doc so I can do it at home or at work and either of us can do it without having to email updated files back and forth. For the first few months, I’m also going to keep all of my receipts and make sure things get entered as we go. After that, hopefully the habit of tracking spending as it happens will become more automatic to us. I think that the Google docs spreadsheet will work great for now, and as long as we do it as we go, there isn’t much of a time commitment. As much as I like when technology can automate tedious processes, I know that unless I type in how much money we spent going out to eat, I won’t notice it as much. While I was learning to budget my money, I did find a terrific looking program called Mvelopes that will link all of your bank accounts, allow you to manage it online from anywhere, do online bill pay, show all expenses from multiple accounts, and let you designate your spending into budget categories and recalculate as it goes along. It utilizes the “envelope concept” of budgeting, but automates it for a cashless society. It’s about $7-$13 a month depending on which plan you choose. I’m really intrigued by the program, but I’m not ready to commit to subscribing to the service until I try out my own system first. But, here’s the sales pitch from them since I think it would really rock and track our expenses in a way that makes sense: “Quicken and Money use the traditional after-the-fact approach, basically a month-end reconciliation of budget to actual spending. With these programs, money is assigned to spending categories only after it has already been spent. You can then run reports in order to see where your money went so you can try better “next time.” It’s a reactive approach to budgeting, which simply does not work. […]